100:1 Leverage Isn't Necessarily a Good Thing
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Here's how to create leverage in a hedge fund (Morris, 113):
- Raise cash by selling partnership shares.
- For every $1 invested, borrow $4 for equity investments. Leverage is now 5:1.
- Buy $100 million in first loss bonds underpinning a $2 billion CDO, $20 million of hedge fund equity, $80 million in loans. This results in a 20:1 leverage.
- Combine the 5:1 and 20:1 leverages and you end up with 100:1 leverage.
Now the good part, or maybe not so good: lose 1% on your CDO investment, wipe out the partner's equity.
That's what 100:1 leverage does. Miscalculate your investment, lose all your money - fast. Multiply your risk and now you have a real problem when the market turns against you. As we all know, the market will turn against you. If you don't have time to recover, you're wiped out. That happened to Long Term Capital Management in 1998. It happened to Bear Stearns in 2007 (Morris, 114).
Welcome to real world high finance.
Reference
Morris, Charles R. The Trillion Dollar Meltdown. Easy Money, High Rollers, and the Great Credit Crash. Public Affairs. 2008.